The Meaning of the Dow Jones Industrial Average

In the last week, the Dow Jones Industrial average closed at a thirteen month high and, at the same time, unemployment hit double digits for the first time since the early eighties. I thought that the Dow Jones was supposed to represent how the economy was doing, but that’s not the case. What does it mean? What is the point of reporting it if it doesn’t mean anything?

The Dow Jones Industrial Average (often called “the Dow” for short) is an incredibly common piece of news, yet the purpose of it is often really unclear to newswatchers. Is it an indication of the state of the economy? Not really. Is it an indication of the state of the stock market? Not really.

Well, then, what is it? And why does it get reported so often?

What Is the Dow?
The “Dow” usually refers to the Dow Jones Industrial Average. It was invented by Charles Dow, a co-founder of Dow Jones & Company, which is a publishing and information company.

The “Dow” is simply an average of the value of one share each of thirty of the largest companies in the United States. It does not include any of the thousands of other publicly traded companies.

Of course, a bit of math checking would reveal that if you added up the current market value of a share of each of the thirty companies in the Dow and divided by thirty, you would not get a number anywhere close to the current value of the Dow. There are several reasons for this, but the most important reason is that companies sometimes choose to split their stocks, basically exchanging two new shares for one old share (or some similar exchange). In order to make sure that such an exchange doesn’t wreck the value of the Dow (because that would effectively mean one of the thirty companies just had a single share of their stock drop by half), Dow Jones & Company accounts for it by using a scaled average, in which they effectively keep track of past splits and multiply the values of each share accordingly. Thus, even when a company splits their stock, it doesn’t affect the Dow average at all.

So, basically, the Dow is just a quick summary of the current value of shares of thirty large companies.

The Value of a Share
But what is the current value of a share?

In simplest terms, it’s all about supply and demand, just like buying and selling anything. The stock market is basically no different than a giant flea market, with many, many people buying and selling thousands of items, all trying to make a profit. Depending on the news (and the behavior of others), the price of individual items goes up and down.

In simplest terms, if there are more people buying than selling, the price of a share goes up. If there are more people selling than buying, the price of a share goes down.

What causes this shift? Information about a given company or about the economy in general. Predictions about what the future holds. The behaviors of others. All of these affect whether people are buying at the moment or selling at the moment.

The Value of the Dow
In effect, the Dow is just an average of thirty items from this giant flea market. What information can we get from that?

Generally, it’s not ruled by news from one specific company. One company’s bad news can affect it a little, but not enough to make a huge difference.

It’s also not affected too much by how things are going right now. It’s important to remember that when people buy and sell stocks, they’re doing it based on what they think the future price holds. Thus, the value of the Dow will often go down well before real economic news (like the unemployment rate) turns bad, and the value of the Dow will often go up well before real economic news turns good.

To put it simply, at the first sign the economy is slowing at all – or that one sector is seeing real problems – the Dow will begin to drop, and often rapidly. At the first sign that a recession is slowing even a bit, the Dow will begin to go up, and often rapidly (and that’s what’s happening right now).

So, look at the Dow as a predictor, nothing more, nothing less. It’s a predictor of the general direction of the economy over the next year or so. If the stock market is going up – as it is right now – the economy will generally improve from its current state over the next year.

the biggest companies in the US are typically multinational. this means they can have sales outside the US, and can employ people outside the US (and in fact the fad for the past 10-15 years has been outsourcing!).

so, the Dow and unemployment can both go up (or down) at the same time — because big companies might be doing well overseas, but not helping to get people employed in the US.

It should be noted that stock market recoveries historically predate job recoveries. This is because as layoffs continue, companies get more productive and profit margins start increasing and eventually there’s a tipping point towards an actual economic recovery. Then companies start hiring again.

Just to expand a bit on what Trent says… the DOW is calculate by adding all the prices together and then dividing by the “DOW Divisor” which is a constantly changing number (currently I think it’s something like .132319…). This divisor changes anytime a stock in the index has a split OR pays a dividend.

This means that currently anytime a stock in the index experiences a $1 increase, it would lead to a roughly 7.55 point increase in the index.

I could be wrong but I think one of the more common criticisms of the DOW is that it doesn’t factor in company size at all. So if a smaller company in the index has a $1 increase it would represent a larger percentage of growth than if one of the very large companies had a $1 increase. The index can’t factor in percentage growths like that though so some think it’s flawed.

Companies are removed from the DOW when they fail and are replaced by other companies. General Electric is the the only company of the original 30 to still be on the list. The latest changes were Cisco Systems and Travelers replaced Citigroup and General Motors.

good intro to the Dow, although I disagree that one company’s stock cannot move the overall average. in any given day, much of the Dow’s movement can be traced to just one or two components.

also, from an economist’s perspective BOTH the dow and unemployment rate are poor indicators of the general health of the market–the stock market tends to lead while unemployment tends to lag, even though investors care more about the former and ordinary folks care more about the latter.

at the moment, the Dow is also being supported directly by all the bank guarantees and other federal (taxpayer) money that is directly subsidizing several components (amex, BoA, jp morgan, the financial arm of GE) and indirectly all the rest. this is just one way in which the current level is not just investors’ collective bet on the American economy.

Jacob (#4): Trent’s post is already quite long, anyone can find the Dow components with Google if they’re that curious.

To follow up on JC’s (9) comments, the idea that the Dow and the unemployment rate are moving in opposite directions is neither unusual nor unpredictable.

The Dow represents the largest traded companies in the country (loosely) and are more affected by factors affecting capital than the economy. The level and direction of interest rates or of the level of government subsidies to major players is more important for the Dow than employment or economic growth levels.

Also important, the term “industrials” is no longer correct. The Dow includes American Express, Bank of America, Travelers, Walt Disney and other companies that manufacture nothing. Also for many companies, a reduction in employment is seen as a positive since it reduces operating costs.

In theory, the Dow could boom while the economy goes bust, given the right combination of circumstances. Not warm and fuzzy like we wish, but the reality of the connection.

jc, thanks for pointing out that a reader with a modicum of initiative can get the Dow components for themselves. Some people do want to be spoon-fed, don’t they?

Trent, thanks for answering this question and pointing out that the DJIA is basically a useless piece of information at the personal-finance level.

I ignore most financial news because my personal economy is so detached from what’s happening nationally, why stress out about it? When I was unemployed, I didn’t need to read about/discuss/obsess over unemployment. When my 401(k) was heading down, I didn’t need to read about/discuss/obsess over the stock market.

When I’m ready to trade, I look up specific companies I’m interested in buying or divesting. Outside of that, “the market” is of no interest to me. Doing well at my job so that I continue to have money to invest IS of interest.

Don’t confuse price with value. These are often two different things. Price is what you pay. Value is what you get.

It is interesting to note that DJIA is price-weighted. This means that the highest priced stock in the index, IBM at $125, has ten times more influence on the behavior of the index, than Alcoa at $13. This also means that if IBM shoots up the index will be doing well. If however IBM gets overvalued, this means that index investors will be “under-buying” the other companies. This is probably the main risk of index investing (as seen in 1999-2000).

not so sure the “Did you not read the rest of the article?” contributed anything to your comment except to make it sound like you’re frustrated when you answered it. thanks for explaining the dow though, was a nice explanation on what it meant!

#3 “….stock market recoveries historically predate job recoveries. This is because as layoffs continue, companies get more productive and profit margins start increasing and eventually there’s a tipping point towards an actual economic recovery. Then companies start hiring again.” A problem this time is that companies have laid off so many people that the economy is losing steam through the laid off folks not having money to consume and the people with jobs cutting back on consuming for fear of losing a job. Also the Fed is pumping money into our system which is not real, so the value of the dollar plummits, it becomes harder and more expensive (think ARM!) to finance America’s debt. Our current government is of a Socialist mindset instead of capitalist. “Capitalism is the unequal distribution of wealth and Communism is the equal distribution of poverty.” One has only to look at the conditons in West Germany vs. East Germay 20 years after the fall of Communism to see a relatively vibrant W. German economy vs. a rural area where the citizens escaped the economic stagnation for the economy of the West as soon as the wall went down.

In my opinion (OPINION before people jump on me again), you have cause and effect reversed. Companies have to lay off people because people aren’t spending.

The cause is the lack of spending, the effect are layoffs. Less people with income to spend, more layoffs. And the cycle continues, until people start spending. A company won’t provide a supply of goods until there is a demand.

The spirit of capitalism is that what’s good for the individual is also for the greater good of everyone else. The decentralization of the banking system proved that untrue. The greed of a few cause a world wide meltdown. Do I need to remind everyone of Madoff?

There is no point in arguing extremes, as there is a fault in pure socialism (communism) and pure capitalism, and that fault is people. In a perfect world where people do what they are suppose to, communism and capitalism would work.

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